Up Next in Europe: A Push for France?

Investors' attention has been focused elsewhere, but France's free ride may be coming to an end as the country's data continues to disappoint.

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Many investors understandably have not focused on France. The threat of scandal in Spain, the need for yet another round of government support for Italy's third largest bank, and the country's upcoming election have commanded attention. What seems to have been a free ride for France may be coming to an end.

Even though the German economy contracted twice as much as the French economy in the fourth quarter, we learned this week that the implications for France are greater. Recent data suggests that the German economy has stabilized and may be expanding, albeit slowly, this quarter. French data continues to disappoint.

This is particularly important because the French government's growth forecast for this year is optimistic, well above the consensus. It was on the basis of the optimism that the Francois Hollande government forecast that France's deficit would fall to 3% of GDP, as the EU requires.

Following news that included the 19th consecutive monthly increase in French joblessness (December) and the larger-than-expected contraction in Q4, the French government will likely soon cut is 2013 GDP forecasts. The issue is whether it does so before or after the EC updates its forecasts at the end of next week. Currently the EC projects 0.4% growth in France, half of the government's forecast.

President Hollande has sold the tax hikes and spending cuts on the basis that they were necessary to reach the 3% deficit target. Senior officials in the Hollande government, including Finance Minister Moscovici, are admitting, just six weeks into the new year, that the 3% target will be overshot. The pushback was nearly immediate. Jörg Asumussen, the German member of the ECB's board, was crystal clear: France and Germany have a special responsibility to meet the 3% target.

Perhaps if one were sitting in the Elysee Palace, EU Commissioner Rehn's comments earlier this week, in which he stated that some members could be granted more time to bring the deficits in line with EU targets, could apply to France. However, it is not clear whether France would be understood to have met the conditionality -- namely, a program in place to correct public finances.

Hollande is under pressure to take additional remedial action. One area that he is being forced by circumstances to address is the pension system which runs a large deficit. Some reports suggest Hollande is preparing proposals that include decoupling pensions from inflation. Pension reforms undermined Nicolas Sarkozy's support and Hollande's support has waned.

In terms of policy, outside of the hike of the marginal tax rate of high-income earners and the modification of the higher pension age introduced by Sarkozy, Hollande's policies as a Socialist do not seem that different. The modest liberalization of the labor market seems perfectly consistent with the Neo-Liberal agenda. Perhaps Hollande has, up until now, relied more on tax increases than the right would have done, but that path appears to have been nearly exhausted and spending cuts loom.

Investors still appear to regard French bonds as slightly better-yielding German bunds. Over the past 60 days, the yield of the 2-year Notes (of France and Germany) move in the same direct 96% of the time. The 10-year yields move together 93% of the time. French yields are inversely correlated to Italian yields, especially in the 2-year area, where the correlation is -63% (vs -11% in the 10-year sector). French bond yields are also inversely correlated with Spanish bonds at -43%. However, the correlation of 10-year bonds is zero, but trending up form -35% in mid-December.

Investors who share misgivings about France should continue to monitor these correlations. A breakdown in the French-German correlation and an increase in the French-periphery correlation would suggest a new phase of euro area tension is at hand.